Why Divestment Doesn’t Hurt “Dirty” Companies

Impact investing is exploding. In 2020, the World Bank’s International Finance Corporation tallied $2.3 trillion in global investments intended to generate social and environmental returns alongside financial ones. The US SIF Foundation, a hub for sustainable and impact investing, estimates that total U.S. assets under management using environmental, social, and governance (ESG) criteria grew by 42% from 2018 to 2020.

So is all that investment having an impact? Jonathan B. Berk, a professor of finance at Stanford Graduate School of Business, is skeptical.

In a new paper, Berk and Jules van Binsbergen, a colleague at the Wharton School, demonstrate that one of the most popular impact-investing strategies — divesting from “dirty” companies that fail to meet ESG criteria — is not nearly as impactful as its practitioners might like to believe.

They find that an overwhelming majority of investors would have to divest to have a significant impact on these companies’ bottom lines. But that hasn’t happened yet, and with just 2% of U.S. stock market wealth currently in “socially conscious” investments, it seems unlikely to occur in the near future.

By selling off their shares, investors give up any influence they may have had over a firm’s corporate policies. As a result, Berk says, impact investors would be better served by hanging onto dirty stocks rather than dumping them — since with enough shares, they could shift corporate behavior by exercising their rights of control.

He spoke with Stanford Business about his findings.

What drove you to do this research?

It was motivated by a general sense that people were assuming something that wasn’t necessarily true. People have assumed that simply divesting from a dirty company will automatically cause the company to change its policies. But the mere fact that you are selling your stock cannot directly affect how corporate managers manage. After all, people buy and sell stocks every day. If anything, it’s going to make matters worse.

If you are a substantial shareholder, then you most likely will have a board presence and can affect corporate policy. But if you sell your stock in a dirty company, you give up that right. And let’s be honest: The people buying your stock are the people least likely to care about social and environmental issues.

But don’t you hypothesize that divestment could potentially generate social and environmental returns by raising the cost of capital for dirty firms?

Yes. When you sell your stock to somebody else, you have to induce them to buy by lowering the price. Most corporate managers envision a day when they will have to go back to capital markets, and if their stock price is low, that means it will be more expensive for them to finance future investments. That’s what managers call the cost of capital. By selling stock, you raise the cost of capital for a firm, thereby reducing the number of investment opportunities it has.

If at the same time you purchase shares of clean firms, that lowers their cost of capital. This means that clean firms will have more investment opportunities while dirty firms will have fewer ones. In the long term, clean firms will grow faster and bigger, while dirty firms will grow more slowly and become smaller.

Eventually the dirty companies will disappear and you’ll be left with nothing but clean ones — which would be good for society if you think that dirty firms have social and environmental externalities.

So far so good. The key point, though, is that for the strategy to work, it must materially change the cost of capital.

To measure the effect on the cost of capital of current divesture strategies, you fed data on current market conditions — the number of ESG investors, the fraction of clean versus dirty stocks — into a mathematical model to see how divestment should change the cost of capital. What did the model predict?

The model predicted a rise in the cost of capital amounting to 0.35 basis points. A basis point is 1/100 of a percent. We estimated the change in the cost of capital to be less than 1/100 of a percent, which cannot possibly make a difference to corporate investment.

And that estimate was based on numbers we could observe — namely, the fraction of money under management that is managed under ESG investment criteria. (The US SIF Foundation almost certainly overestimates the fraction of ESG investors; SIF is, after all, a trade group that promotes ESG investing.) But even when we used its estimate, the predicted effect on the cost of capital is only 8 basis points, or 0.08 of a percent — still too small to have any impact on the investment decisions of firms.

You also analyzed market data from the early 2000s through 2020 to calculate the historical effect of divestment on the prices and returns of clean and dirty stocks. Did your findings match the model’s predictions?

If a firm becomes either clean or dirty, we should see a price change due to the transition. If you look for that, you’ll find it. But it’s very, very, very small — in line with what we predicted, and too small to possibly affect how firms are investing.

But if enough people were to divest from dirty firms in the future, wouldn’t that have a meaningful impact on the cost of capital at some point?

To impact the cost of capital by at least 1% requires that at least 86% of investors choose to hold only clean stocks. It seems very unlikely to me that you could convince so high a fraction of investors to adopt ESG policies.

So what’s the takeaway for impact investors?

If you really want to effect change, divestment is unlikely to be successful. Just selling stocks is not going to make a difference.

If investors know that they are having no effect but still feel good about what they’re doing, then there is nothing wrong with that. But if they are paying a money manager to pursue a strategy that they believe will make a difference because their manager convinces them that they are having an effect when they really are not, then that worries me.

What’s the alternative?

The best way to effect change is to invest, not divest.

You can estimate the number of dirty firms by looking at all the companies whose stock has never been purchased by an ESG mutual fund. That’s about 18% of all stocks. You do not need anywhere near 86% of investors to buy a big enough stake in that 18% to actually change corporate policy. Often you do not even need a majority stake to replace the management. By focusing on just these companies, it would take far less than 18% of investors to effect change.

That seems like more work than just selling shares.

Yes, it is a lot of work, but I don’t see an alternative. The truth is that it takes effort to change the world.